Advanced Definition of Free Cash Flows for Use in the Enterprise

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APPENDIX 17.3 Advanced Deﬁnition of Free Cash Flows for Use in the Enterprise Valuation Method

n this appendix, we give readers some general guidelines on how to estimate free Icash flows derived from the financial accounting statements of a business. This guidance will be of practical use when navigating real-life accounting statements. Be aware that these suggestions are not a comprehensive treatment of either cash flow determination or accounting measurements. For more in-depth explanations, especially of advanced topics, we suggest you seek professional accounting advice and consult applicable local accounting rules that are pertinent to your particular business situation and valuation objective. The general accounting principle to keep in mind is that (1) every increase in an asset account (or decrease in a liability account) must be subtracted from the cash flow, and (2) every increase in a liability account (or decrease in an asset account) must be added to the cash flow. Table 17A3.1 depicts a general determination of free cash flows and includes a simplified treatment of operating leases and foreign currency translations. We discuss the treatment of purchased goodwill arising from business combinations in the section called “Accounting for Goodwill.”

OPERATING LEASES

Operating leases are complex because they require an advanced understanding of financial statements, tax implications of the lease, company depreciation policies, and the actual financing terms of the lease. Professional accounting advice is advisable when confronted with an important leasing decision. Long-term leasing is a form of financing property, plant, and equipment. The lessee is the user of the asset or equipment; the lessor is the owner. From the lessee’s viewpoint, long-term leasing is similar to buying an asset or piece of equipment with a loan secured by the asset or equipment. Thus, long- term leasing is a form of financing. Leases often arise, for example, when a company signs a contract to lease its office space, office equipment, major laboratory

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TABLE 17A3.1 Determination of Free Cash Flow

Line No. Item

1 Revenues 2 less Cost of goods sold 3 less Selling, general and administrative expenses 4 less Depreciation 5 less Goodwill impairment or amortization of goodwill1 6 plus Implied interest on operating leases 7 equals Earnings before interest and taxes (EBIT) 8 less Taxes on EBIT 9 plus Any increase (or minus any decrease) in accumulated deferred tax liabilities; or 10 plus Any decrease (or minus any increase) in accumulated deferred tax assets. 11 equals Net operating profits less adjusted taxes (NOPLAT) 12 plus Goodwill impairment or amortization of goodwill∗ 13 equals Net operating profits less adjusted taxes plus amortization for goodwill (NOPLATPA) 14 plus Depreciation expense (including any depreciation expense associated with the capitalized operating leases) 15 equals Gross cash flows 16 less Any increase in working capital; or 17 plus Any decrease in working capital 18 less Capital expenditures 19 less Investment in goodwill 20 equals Free cash flow from operations 21 plus Non-operating cash flows 22 plus Any increase in foreign currency translation adjustments 23 minus Any decrease in foreign currency translation adjustments 24 equals Free cash flows to the enterprise

∗Under current U.S. GAAP, only goodwill impairment is allowed for goodwill arising from business combinations accounted for by the purchase method. (Refer to FASB SFAS 142.) In other countries, local accounting standards may permit goodwill amortization. Sources: Financial Accounting Standards Board SFAS 141R (Revised 2007) and SFAS 142; Tom Copeland, Tim Koller, and Jack Murrin,Valuation: Measuring and Managing the Value of Companies (New York: John Wiley & Sons, 2000), pp. 163–165; George Athanassakos, “Note on the Discounted Cash Flow-Based Valuation Methodology as Tested by a Pub- lic Market Transaction” (IVEY 9B05N021), Richard Ivey School of Business, University of Western Ontario, 2005, pp. 1–24.

equipment, or other types of industrial machinery. The major economic benefit of leasing is tax reduction; other benefits might be to minimize transaction costs or reduce uncertainty.1 Accounting rules determine whether a lease is an operating lease that is off-balance sheet (meaning it is not recorded on the balance sheet), or a financial (capital) lease (meaning the financial lease is capitalized). When a financial or capital lease is capitalized, the present value of the lease payments must be calculated and shown alongside debt on the right-hand side of the balance sheet. The same amount must be shown as an asset on the left-hand side of the balance P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come

Appendix 17.3: Advanced Deﬁnition of Free Cash Flows 3

sheet. This “asset” is then depreciation over the life of the lease. The depreciation is deducted from income, just as depreciation is deducted for any purchased asset. The corresponding balance sheet effect is that both the capitalized asset and debt are reduced by the amount of the depreciation.2 Actually, there are many types of leases, but it is beyond the scope of this appendix to discuss them all in detail. In Table 17A3.1, we treat operating leases from the point of view of the lessee. We are assuming that the company is paying a monthly or annual leasing fee in exchange for the right to use the leased equipment over the life of the contract but does not own the asset. The lessor retains ownership of the equipment. To carry out an enterprise valuation of a company with operating leases, we need to adjust the company’s financial statements and also the free cash flows to treat operating leases as if they were capitalized. The rationale is that operating leases, being a form of debt financing, should be treated the same as capital leases. Recall that in an enterprise valuation, we focus on unleveraged free cash flows (i.e., excluding the effects of financing). For simple operating leases, these six steps are the basic adjustments:3

Step 1. We reclassify the implied interest expense portion of the lease payments from an operating expense (usually found in cost of goods sold, or in selling, general, and administrative expense) to an interest expense. This reclassification increases earnings before interest, taxes, and amortization (EBITA) by the amount of implied interest. (Refer to line 6 of Table 17A3.1.) Step 2. At the same time, we need to remember to adjust EBITA taxes for the effects of the reclassification done in Step 1. Step 3. Next, we add the implied principal amount of operating leases to the amount of invested capital and to debt. In effect, we are increasing the asset side of the balance sheet at the same time we are increasing the liabilities side of the balance sheet for the capitalized portion of the principal amount of the operating lease. However, these balance sheet adjustments have no net effect on the free cash flows shown in Table 17A3.1, so we do not need to do any adjustments for Step 3 in the table. Step 4. We now add back the depreciation expense associated with capitalizing the operating leases to line 14 in Table 17A3.1. Step 5. Then we treat the principal amount of the lease as additional debt in the weighted average cost of capital (WACC) calculation. (Refer to Chapter 17.) We need to be sure that the WACC incorporates the impact of the leases. Step 6. We add back any surplus cash and then subtract the amount of capitalized operating leases and debt in order to calculate the final equity value of the firm.

With operating leases, sometimes it is difﬁcult to estimate accurately their total value. For our example, we wish to estimate the value of an operating lease by capitalizing the stream of lease payments by an appropriate cost of debt. Capitalizing the stream of payments can be done several ways. One approach is to take the current year or next year’s lease payment and divide by the cost of debt (as if it were a perpetual bond or a terminal value with no growth). Another approach is to discount the future minimum lease payments at the company’s marginal borrowing rate. In the United States, accounting rules require the amount of lease payments to P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come

4 APPENDIX 17.3: ADVANCED DEFINITION OF FREE CASH FLOWS

be disclosed in the footnotes to the financial accounting statements. Be aware that the present value of the future minimum lease payments may underestimate the value of any leases that management intends to renew. Finally, to estimate the implied interest expense on the operating lease, simply multiply the implied principal amount (the capitalized amount) by the marginal borrowing rate. We show the result on line 6 in Table 17A3.1. Once we have finished making all the adjustments, we then follow the normal procedure described in Chapter 17 to discount the operating free cash flows of the firm by the adjusted WACC to compute the value of the whole firm (entity value). Recall that in the enterprise valuation method, we indirectly estimate the value of the shareholder’s equity as a residual after subtracting various items from the total value of the enterprise. Starting with the total enterprise value of the company, we must subtract the market value of short-term debt, long-term debt, any capital leases, the value of any operating leases, preferred stock, minority interests, and warrants and stock options from the total value of the enterprise. The equity value is the value that remains. For purposes of our operating lease example, these relationships hold:

Enterprise Value + Surplus cash − Short-term and long-term debt − Value of capitalized operating leases = Equity value

FOREIGN CURRENCY TRANSLATION ADJUSTMENTS

In this appendix, we assume that foreign currency translation adjustments flow through to the income statement either as an expense (or an addition) to income. Therefore, in the determination of cash flow, we need to either add back (or deduct) the same amount as a noncash charge similar to the handling of depreciation expense, depending on whether it is an increase in a liability or an increase in an asset. For illustrative purposes, assume that a European company has borrowed US $100 million that is equal to €80 million. Each quarter, the company needs to translate this liability into euros for its regular financial statement filings. If over the quarter, the U.S. dollar strengthens relative to the euro, then the company would need to recognize, say, an $8 million loss on its income statement due to the weaker euro relative to the dollar. (The company needs more euros to pay back the same amount of dollar loan.) In terms of the cash flow determination, the analyst needs to add back the $8 million loss from the company’s income statement because the foreign exchange translation loss is a noncash charge to income that increases the foreign exchange loss adjustments. (See Table 17A3.1, line 23.) Next assume that the same company has a $20,000 accounts receivable coming due. Over the quarter, the U.S. dollar strengthens, as in our previous case. For the account receivable, the strengthening dollar is good news, as it means the company will receive more money (in equivalent euros) at the end of the quarter than it would have received at the beginning of the quarter, all other things being equal. Consequently, the analyst will show a gain in income due to the foreign exchange translation on P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come

Appendix 17.3: Advanced Deﬁnition of Free Cash Flows 5

the accounts receivable and a corresponding decrease in foreign exchange loss adjustments. At the same time, the analyst should deduct this foreign currency gain in the cash ﬂow determination. The reason it is subtracted in the cash ﬂow determination is that the accounts receivable foreign exchange translation adjustment is a noncash gain that decreases foreign exchange translation losses. (See Table 17A3.1, line 24.)

ACCOUNTING TREATMENT OF GOODWILL

What exactly is goodwill? According to generally accepted accounting principles in the United States (U.S. GAAP) and Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standard 141-Revised 2007, Business Combina- tions (SFAS 141R), goodwill is defined as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.”4 In simplified terms, it represents the difference between total acquisition cost and the fair value of assets acquired in business combinations. Fair value is “the price received to transfer an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”5 Purchased goodwill arises whenever a company acquires another company and pays more than the fair market value (FMV) of the assets shown on the balance sheet and accounts for the business combination using the purchase method of accounting.6 Purchased goodwill is recorded on the acquiring firm’s balance sheet as an asset. A simple example will help clarify the recording procedure. Assume two firms have identical expected revenues for the next year, 2010. Their income statements and balance sheets are similar in size and cost structure. The target firm has grown more quickly than the buyer firm and is expected to keep up its sales growth and profit momentum—making an acquisition especially attractive to the buyer. The business combination transaction is anticipated to close early in the year 2010. The deal terms contemplate that the buyer will pay a total of $3,000 in cash for the target’s stock (a market value of $3.00 per share). Also, the buyer will assume $1,950 of liabilities (current and long-term) of the target. The total consideration paid (purchase price paid) for the target is therefore $3,000 + $1,950 = $4,950 using the next formula:

Equity cost + Liabilities assumed = Purchase price

How much goodwill is created? The goodwill is the purchase price minus the fair market value of the identiﬁable assets of $3,950 (assumed to be allocated $300 to current assets, $700 to intangible assets, and $2,950 to gross ﬁxed assets). The amount of goodwill is the residual amount or $1,000 as computed using this formula:

Purchase price − Fair market value of identiﬁable assets = Goodwill

Using the same two ﬁrms as in the previous example, how would the asset revaluation for ﬁnancial accounting purposes take place? The total consideration paid remains $4,950. On the accounting books of the target, the preacquisition P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come

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book values of its gross fixed assets amounted to only $1,900. Assume that current assets were already at $300 and identifiable intangible assets were recorded at $700. In this simplified illustration, the target’s gross fixed assets are the only category to experience an increase in recorded cost (reflecting the higher fair value of the gross fixed assets). As a result, on the closing date of the acquisition, the target’s gross fixed assets will be revalued for financial accounting purposes from the historical cost book value of $1,900 to the closing date’s fair market value of $2,950 (an increase of $1,050). In essence, the financial accounting for such a business combination (in this simplified example) is a two-step process that works like this:

1. Equity cost − Book value of the target = Excess equity cost 2. Excess equity cost − Revaluation of net assets to FMV = Goodwill

Warren Buffett is the world’s richest investor and a former student and associate of the legendary professor Ben Graham of Columbia University. Buffett is quoted as saying: “An analyst can live a rich and fulfilling life without ever knowing about goodwill or its amortization.”7 Buffett’s point was that purchased goodwill and its amortization are not useful pieces of information for investors. Therefore, the analyst should eliminate the effect of these items. Referring again to Table 17A3.1, you might wonder why we show in line 5 the item amortization of goodwill and then again, in line 12, the elimination of amortization of goodwill (by subtracting the item), an action that is generally consistent with Buffett’s position. We eliminated goodwill amortization from the cash flow determination because, similar to depreciation, goodwill amortization is a noncash charge and therefore it should have no impact on cash flow from operations. Why show both goodwill impairment and amortization of goodwill? Under SFAS 141R, goodwill amortization for business combinations is prohibited; testing for goodwill impairment is required instead (hence line 5 includes goodwill impairment). The accounting standards in other countries still permit purchased goodwill amortization (so we included the possibility for amortization of goodwill in line 5). However, when amortization of goodwill shows up in the financial statement, the analyst needs to eliminate it (as we have shown in line 12) in order to correctly determine free cash flow.8 Accounting standards around the world vary, and they are continuously being updated. As mentioned earlier, readers should seek qualified accounting experts for professional advice. In Appendix 18.1, we give further explanations (for the advanced reader) about current FASB accounting standards in the United States for goodwill and intangible assets and business combinations.

NOTES

1. For a more complete discussion of leasing, refer to Stephen A. Ross, Randolph W. West- erﬁeld, and Jeffrey Jaffe, “Leasing,” in Corporate Finance, 4th ed. (Chicago: Richard D. Irwin/Times Mirror Higher Education, 1996), pp. 626–651. 2. The explanation of ﬁnancial (capital) leases is from Richard A. Brealey and Steward C. Myers, Principles of Corporate Finance. 4th ed. (New York: McGraw-Hill, 1991), pp. 653–672. P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come

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3. Operating lease adjustments are briefly covered in Tom Copeland, Tim Koller, and Jack Murrin, 2000. Valuation: Measuring and Managing the Value of Companies,3rded.(New York: John Wiley & Sons, 2000), p. 177. 4. Quote is from SFAS 141R, para. 3j, p. 2. The full text of SFAS 141R is downloadable from the FASB Web site at this link: www.fasb.org/pdf/fas141r.pdf. 5. See Financial Accounting Standards Board Statement of Financial Accounting Standards 157, Fair Value Measurements (SFAS 157), issued in September 2006. SFAS 157 became effective for fiscal years beginning November 2007. We note that the simple phrase “or paid to transfer a liability” is causing debate among the FASB members under the current deteriorating credit market conditions: How should companies estimate the market value of liabilities when there is no actual market on which to base the estimate? Such matters are beyond the scope of this book. 6. To better understand the purchase method versus the pooling-of-interests method and how these two accounting methods affect pro forma financial statements for business combinations, refer to Robert F. Bruner. Applied Mergers and Acquisitions (Hoboken, NJ: John Wiley & Sons, 2004), pp. 478–510. 7. Warren Buffett is quoted in Sidney Cottle, Roger F. Murray, and Frank E. Block, Graham and Dodd’s Security Analysis, 5th ed. (New York: McGraw-Hill, 1988), p. 235. 8. Advanced readers may wish to refer to Appendix 17.4, “Five Ways to Estimate Ter- minal Values,” which is located on this book’s web site (www.innovationtocashflows. com). Toward the end of that appendix in the section called “Fine-Tuning the Free Cash Flow Definitions in the Terminal Value Expression for Constant Growth,” we show how NOPLATPA is an input for more advanced terminal value estimate. NOPLATA eliminates any goodwill amortization distortions on future net operating profit projections. P1: ABC/ABC P2: c/d QC: e/f T1: g app17p3 JWBT060-Lutolf May 22, 2009 13:3 Printer Name: Yet to Come